Seven Ways To Slow The 'Tax Drag' On Investments

It's not how much you earn that counts; it's how much you keep. Yet for many investors, a combination of taxes can siphon off close to half of their investment earnings. Some of what you earn from your investments may be taxed at ordinary income rates up to 39.6% on the federal level, plus you could be hit with a 3.8% tax on "net investment income" (NII) as well as state and local income taxes.

What can you do? Consider these seven approaches:

1. Know the benefits in the law. Congress has had more than 100 years to tinker with the tax code, which now is full of provisions designed to protect and enhance the interests of investors. The complete list, too long to enumerate here, includes tax breaks for investments in real estate, employer-based retirement accounts and IRAs, and life insurance, as well as others such as oil and gas partnerships.

2. Take advantage of breaks on long-term capital gains and dividends. If you sell securities you've owned for more than one year, you may benefit from preferential tax rates for long-term capital gains. The maximum tax rate is 15% for most investors and 20% for those in the top 39.6% tax bracket for ordinary income. There's also a 0% rate for investors in the two lowest ordinary income brackets of 10% and 15%. These favorable rates also apply to most dividends from U.S. companies.

3. Find the best way to save for higher education. Paying for college is a tough nut to crack for many parents. Fortunately, the tax code provides incentives for saving—especially Section 529 college savings plans. Run by the states, these plans offer tax-deferred investment compounding and as long as account withdrawals go to pay tuition, room and board, and other "qualified" expenses, those too are exempt from tax. Other tax breaks for parents, including tuition deductions or higher education credits, have a much smaller impact and aren't available to upper-income savers.

4. Rely on retirement accounts and IRAs. If you participate in a retirement plan where you work, such as a 401(k) plan or a "defined benefit plan" (such as a traditional pension plan), the money contributed to your account grows tax-deferred; you're taxed only when you make withdrawals. You also can contribute to a traditional IRA or a Roth IRA outside of work. Those funds also grow untouched by taxes, and most Roth IRA withdrawals during retirement are tax free.

5. Consider master limited partnerships (MLPs). MLPs often are misunderstood. Because they pass along taxable income to their partners, MLPs themselves aren't subject to corporate income tax. That eliminates the "double taxation" problem of most corporations, which pay corporate tax and then see the dividends paid to shareholders taxed as well. Partners who sell MLP shares are taxed on the difference between the sales price and the adjusted basis (what they paid for the shares adjusted according to tax rules).

6. Explore the real tax benefits of real estate. Investing in real estate long has been associated with tax breaks. For instance, if you invest in commercial or rental properties, you're eligible to deduct expenses such as property taxes and repair costs. You also may be able to claim a generous allowance for depreciation even as your holdings may be gaining value. However, when you sell, depreciation allowances may be taxed. Another tax-savvy technique is to exchange similar properties tax-free, subject to restrictions, under Section 1031.

7. Look at annuities and life insurance. An annuity is a contract between you and a financial institution (often an insurance company) that provides regular payments for a term of years or for your lifetime. With a tax-deferred annuity, a common variation, payments are set up to "leapfrog" your high-tax working years. And proceeds at your death from a life insurance policy are completely free of income tax.

MLPs and real estate investment are income-generating investments that may offer attractive yields and distribution growth rates, but they are complex investments with unique tax characteristics and significant risks. As a result, MLPs and real estate investments may not be suitable for all clients. It is important to understand all the features, characteristics and risks of any particular security under consideration for your account. Consult with a tax advisor before investing in MLPs or real estate.

This article was written by a professional financial journalist for Alpha Wealth Strategies and is not intended as legal or investment advice.